In March 2012 the ATO issued TD 2012/1 stating they would apply Part IVA do deny a deduction for capitalised interest if the dominant purposes of the arrangement was for a tax benefit and they do not consider wanting to pay your home off sooner to be an alternative dominant purpose.
This ruling may come as a shock for some investors who have paid many thousands of dollars to finance brokers and property spruikers for such an arrangement. It certainly makes us feel a lot better about our conservative, get a private ruling approach.
So What is Capitalised Interest?
Capitalised Interest is interest charged on interest. In other words you didn’t make the interest payment on a loan or you borrowed to make it so the next month you are going to be charged interest on the previous month’s interest.
Capitalised interest is tax deductible if the original interest was deductible but the ATO can deny the deduction, by using Part IVA, if it decides your dominant purpose was to obtain a tax benefit.
The ATO has previously issued some private rulings that took a reasonable approach but TD 2012/1 takes a much narrower view and of course has precedent over private rulings.
A Summary of TD 2012/1
TD 2012/1 uses terms like “typical but not always”, to draw in most circumstances, possibly hoping to squash the issue once and for all. Bear in mind that the ruling is only saying that it does not accept it will apply Part IVA to situations where the taxpayer argues that their dominant purpose was only to pay their home loan off sooner The full text of the ruling is available in the menu on the top right of this page.
It says – “A taxpayer’s purpose of paying their home loan off sooner or owning their own home sooner does not prevent the application of section 177F (Part IVA) to an investment loan interest payment arrangement of the type described in paragraph 3”. Paragraph 3 then goes onto attempt to cover any arrangement where there a rental property loan and a home loan and the interest payments are not paid ie they compound, or are borrowed from another loan. This applies even in a line of credit where there is no requirement to make the interest repayments. Now here is the kicker:
(h) Typically all or a significant portion of the taxpayer(s) available cash inflows (including that which the taxpayer(s) otherwise might reasonably be expected to use to pay the interest on the investment loan) are deposited into their home loan or an acceptable loan account offset account which has the effect of reducing the interest otherwise payable on the home loan.
Notice how it doesn’t specify what you are required to do with the rent. This ruling is requiring you to make those interest payments no matter what, even if you are not required to by the bank because of the available credit in your loan and even if the rent is not enough to cover the interest payments. There is no consideration, as was given in Hart’s case, that if you can’t afford to meet the payments it was ok.
This ruling is implying that the interest must be your first concern even though you have no obligation to pay it. At this point in the ruling it is important to remember the title of the ruling. It is only addressing a situation where a taxpayer is arguing that their dominant purpose is not the tax benefit but simply to pay their home loan off sooner.
The ruling would have been much more objective if it had pointed out a few things like its ok to buy food, but that would distract from its scare tactic value. Many issues are not addressed in this ruling, many accepted conventions are left in doubt. For example what if you have a rental loan that is interest only and your home loan is principle and interest. That was once acceptable but now isn’t that an arrangement to pay your home off sooner? Nothing artificial or contrived but the ruling also forgets that little safe guard in the explanatory memorandum for Part IVA.
What if you have a typical loan and something goes wrong with the rental or for that matter you have medical expenses? You are sweet with the bank because you have available borrowings in the rental property loan, you are not actually required to make repayments because it is a line of credit. Nevertheless, if you dare take what little money you have left and make the required payment on your home loan you will be caught by this ruling. It is far too wide and poorly considered and needs to be challenged in the courts.
The ATO is hesitant to test Part IVA in the courts because the legislation previous to Part IVA was so narrowly read by the courts it became useless to them. So the ATO strategy is one of scaring and bullying rather than giving clear information about the application of the law. With the ATO’s unlimited taxpayer funded ability to appeal any decision it does not like, it is a brave person who will seek justice.
Many years ago the Government set aside an amount in its budget to help fund individual taxpayers to challenge important points of tax law. Unfortunately, it is the ATO that gets to decide who receives this money.
The absolute absurdity that the ruling is based on is shown in paragraph 10 where it says “In relation to this type of scheme it might reasonably be expected that if the scheme had not been entered into or carried out, the taxpayer would have met the interest payments on the investment loan out of their own cash flow rather than use the line of credit” Now why would they do that when the LOC does not require repayments to be made?
Enough ranting, what to do now? How do we move forward? Well you have a real problem if the rent does not cover the interest repayments and other expenses and until now you had been getting by, by borrowing the difference in accordance with PBR 69725. It now appears you do have to top up your investment from your wages!
You see if your normal every day account is offset against your home loan or your home loan is principle and interest yet the rental loan is interest only you have an arrangement that pays your home loan off sooner. It is no longer a question of looking for contrived arrangements this ruling catches all and until the courts apply some sanity to the situation taxpayers need to be very careful that they make these interest payments no matter what. If they don’t then the interest charge must be apportioned between interest on top of interest and interest on the original borrowings, which is a record keeping nightmare. Oops ranting again!
Now it is not for the ATO to tell taxpayers how to manage their finances this has been long settled by Tooheys Ltd v FCT in 1922, Tweddle v FCT in 1942 and Case F17 in 1955. Further, in Hart’s case it was stated “It may mean no more than that, in considering the terms of the borrowing for investment purposes, the taxpayer took into account the deductibility of the interest in negotiating the terms of the loan. How could a borrower, acting rationally fail to take this into account?” This statement supports the use of interest only for a rental property and principle and interest for your home loan but of course that is assuming you are not capitalising interest. Note Hart’s case made it quite clear that capitalised interest is tax deductible, the ATO is just saying they will disallow it because it is a scheme to avoid tax.
Applying for a Private Ruling
Before you make a claim for capitalised interest when, you also have non deductible debt you should apply to the ATO for a private ruling. If your circumstances are basically the same as described in TD 2012/1 just expect them to refer you to it. You see they don’t have to decide what exactly your dominant purpose is. They only have to decide what a reasonable person would consider to be the dominant purpose of the arrangement. So there is no point in saying but honestly this is why I am doing it.
There are many circumstances where capitalised interest may well be tax deductible but in view of the approach taken in TD 2012/1 you should still apply for a ruling. Here are some situations where it would be nice to have a statement from the ATO.
- You are currently asset rich but cashflow poor (maybe maternity leave). You can afford to make your home loan repayments but not all of the interest repayment on the rental property for the next few years. Can you claim the interest that capitalises as a result? Point out that during this time you hope that the balance of your offset account (offset against your home loan) will increase as naturally you want to save for a family holiday or have a safety net for unforeseen circumstances. Choosing to do this through the offset account attached to your home loan is practical as your only other source of funds in an emergency is the LOC used to pay rental property expenses. If this was accessed for private purposes it would create the record keeping nightmare of interest apportionment on a mixed purpose loan.
- Your home loan is over 10 years so the repayments are high, add to this a detailed budget of your living expenses and you just can’t afford the interest repayments on the rental property but fortunately, you have enough equity to secure a LOC for these borrowings.
- You have organised the LOC so that you have all the rental property expenses recorded separately and on one statement and so that you can be sure that payments are met when due because you have so much available credit. All your income is directed to the offset account for you home loan. The question you have for the ATO is what happens when due to the order that expenses are drawn from the LOC or because the property is negative cash flow or because you are not that organised and irregularly transfer money into the LOC and then only what you feel you can afford considering possible private expenses. As a result of any of these interest will capitalise on the LOC is this also caught by Part IVA. Is the dominant purpose of your lack of attention to your accounts on a daily basis, to obtain a tax benefit?
- It is your intention to start a family as soon as it is financially viable but it is a personal choice that during the first few years of your children’s life that you will live off one wage. To be able to manage on such a reduced income you will need to be far enough ahead on you home loan to not be required to make repayments during that period. The question for the ATO is whether letting interest capitalise on you rental property while saving to have a family is a scheme with the dominant purpose of a tax benefit.
- You had thought you could meet your financial commitments but due to a change or circumstances such as pregnancy, demotion, unemployment, sickness etc you are finding it difficult to pay your bills and are anxious about future doctor’s bills unemployment etc. You wish to concentrate all your income towards you offset account to ensure you can meet your home loan repayments and emergencies. Fortunately, you have plenty of equity so can use a LOC to support the rental property. Is the ATO going to use Part IVA to force you to borrow for personal expenses rather than rental property expenses?
- The interest rate on your private debt is higher than that on the LOC. This maybe because your private debt is a credit card or car loan. It may even be the case with your home loan. This scenario may even be the one opportunity where the way the loans are organised can affect the success of your arrangement. In this case you argue that your dominant purpose is simply to reduce your interest expense by paying the highest interest rate loan off as soon as possible.
- If you have sufficient equity in assets other than your home to finance the growing LOC debt then the concept of paying off your home sooner has much more punch. You dominant purpose could be to make sure that only your rental properties are exposed to risk of mortgage repossession.
Make sure your ruling request specifically asks the ATO to answer whether Part IVA would apply to deny you a deduction for capitalised interest. If the ATO does not respond to your ruling application within 28 days you can lodge a complaint with the ATO. If that does not produce a result you are then entitled to have the Taxation Ombudsman take the matter up on your behalf.
Now if you are about to refinance or purchase a rental property then here are some ideas on how to set up your loan arrangement so that you are likely to be in the best position to take advantage of any circumstances where the ATO concedes capitalised interest is deductible. No guarantees here but the following loan structure avoids most of the obvious traps though of course at this stage do not claim any capitalised interest without first obtaining an ATO ruling:
- Use all the available equity in your own home to secure a loan for the maximum amount you can. Use this loan to pay for the rental property. No doubt you will need more than that. The second loan can be secured by the investment property but this should leave available equity in the investment property to secure a line of credit should you later want to do so. This further reduces the link between the loan where the interest will be capitalised and your home. The ATO cannot argue that effectively you are not reducing the debt on your home but only shifting debt from non deductible to deductible.
- Do not have the home loan linked to other loans ie with a floating cap. It is fine to have a split facility with all your deductible debt but keep the home loan outside of this facility.
- Do not use a product that is marketed in any way for tax benefits.